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In business, nothing speeds forgiveness like success. Citigroup cranked out a record $4.1 billion in earnings from continuing operations in the first quarter of this year, and followed it with $4.3 billion the following quarter. That performance moved investors, who had driven the stock price down to $24.42 last summer as a result of Citigroup’s repeat appearances in financial scandals, to nearly double it by mid-October.

But forgiveness didn’t come without some very public penance for the financial-services giant. In April, the firm’s Salomon Smith Barney division (now called Citigroup Global Markets) forked over $300 million in fines plus $100 million in additional restitution as part of the so-called global settlement with regulators over misleading research. As employer of the poster child for conflicted research—telecommunications analyst Jack Grubman—Citigroup’s fines were the largest of any financial institution (see “The Global Settlement” at the end of this article).

Critics will note that the fines amount to less than a week’s worth of earnings so far this year. Somewhat harder to dismiss are public expressions of regret by Citigroup executives—particularly given the number of still-looming shareholder suits—and the firm’s laundry list of internal reforms (see “New Leaf or Fig Leaf?” at the end of this article). Prudential Equity Group’s Mike Mayo derided some of those reforms last year as “just-in-time corporate governance,” but even that notoriously bearish analyst had to bow to Citigroup’s financial performance, upgrading the firm from “sell” to “hold” this past July. That same month, Citigroup settled enforcement proceedings with the Securities and Exchange Commission over structured financings for Enron and Dynegy, earning a curt acknowledgement for its cooperation.

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CFO Todd Thomson insists Citigroup isn’t just playing catch-up when it comes to reform—he claims it’s now trying to use its enormous market presence to lead the way. And that includes setting some standards for what it will and won’t do for its corporate customers.

“Anything Citigroup can do to show leadership in regaining trust with investors we should do,” says the 42-year-old Thomson. That includes obvious corporate moves such as expensing options (despite his historical opinion that the accounting treatment is incorrect) and raising Citigroup’s dividend by 75 percent.

When it comes to actually turning over a new leaf, of course, results are harder to gauge. The true test of Citigroup’s reforms will be its ability to remain scandal-free despite its staggering breadth of financial offerings and sprawling global operations.

When it comes to his own finance organization, which spreads across more than 100 countries, Thomson, who took over as CFO in March 2000, shuffles finance executives around the world to make sure their ultimate allegiance is to his office in New York, not their local business unit. “I want to establish—and have established—a culture of integrity in the finance organization,” he says. “That happens only if I’m viewed as having personal integrity.”

At the very least, one can certainly say Thomson puts his money where his mouth is. Under Citigroup’s so-called blood oath, executives must hold at least 75 percent of Citigroup shares they receive. “I have never sold a share yet,” says Thomson. “One-hundred percent of my net worth is in Citigroup stock.”

Senior writer Tim Reason sat down with Thomson in mid-September to discuss just how much Citigroup has changed, and what that might mean for its customers.

You had a record $4.3 billion in income from continuing operations in the second quarter. Given the turmoil of the past 18 months, you must be very pleased.

Yes, I think these are tremendous results. It’s a testament to the dedication of the management team. To not be distracted by newspaper stories, but to stay focused on customers and on building a growing business was a terrific challenge. It’s also a testament to the franchises we have here. We’ve got a credit-card business, a consumer-finance business, our corporate investment bank—those are all the biggest and the best-run in the industry. That allowed us to continue in a very difficult economic environment globally and deliver terrific financial results.

Last year was a terrible one for your stock price. Now your stock is back up.

Well you know, as CFO you’re never satisfied with where the stock is. We’re not getting nearly the premium we deserve. But I think it will come.

Is the premium low because of the economy, or is it the result of a lingering aftertaste of Enron, WorldCom, and all those other distractions?

I think it has less to do with some of those issues and more to do with the fact that the company really is only about five years old. It was created by combining CitiCorp and Traveler’s at the end of 1998. If you look back over the past 10 years, earnings per share have grown more than 20 percent a year. But it takes a while for investors to get comfortable that going forward, the new company will deliver the same kind of performance.

Also, as the world has changed, there has been concern about big, complicated, global companies, and we are one of the biggest and most complicated. Over time, people will get comfortable that a company this size can be managed very well for growth, and that we can continue to deliver quarter-on-quarter.

And we’re hopeful that the geopolitical situation will settle down a bit. I think that will be helpful to the stock as well.

You think the geopolitical situation is hurting Citigroup’s stock?

I think those are bigger overhangs than the specific issues from last year.

Citigroup sponsors major conduits for issuing asset-based commercial paper. What affect did FIN 46 [FASB’s ruling on consolidation of variable interest entities] have on the special-purpose entities [SPEs] that serve as those conduits? You did not ultimately have to consolidate them onto your balance sheet.

Right. The Financial Accounting Standards Board scoped out qualifying SPEs, so things like our securitization vehicles for credit cards were [not changed by] FIN 46. I don’t think there are abuses in those. [Qualified SPEs] help the U.S. capital markets operate more efficiently, and securitization of credit cards has been a very valuable part of the development of the capital markets.

Commercial-paper conduits were [not excluded from FIN 46.] We provide a service, essentially, for customers. They have assets, they want to get funded, and they want to issue commercial paper backed by those assets. We offer a way to intermingle various customers’ assets and then offer [commercial paper backed by those assets] to the marketplace. We provide a service that’s not that much different from a mutual fund.

According to FIN 46, we would have had to consolidate about $55 billion of customer assets under our balance sheet. I don’t think it’s reasonable for us to do that. So we asked, “Is there a way to structure these vehicles that meets the new FIN 46 requirements to keep the customers’ assets off our balance sheet?” And we realized that we could restructure the assets by selling off some first-loss positions to outside, unaffiliated investors.

Because if outside investors hold the expected-loss tranche, FIN 46 defines them as the primary risk taker, and they must consolidate the assets on their balance sheet, correct?

Yes. And we have actually gone through—in detail—with the SEC, with the Federal Reserve, and with FASB the approach we’re using for restructuring. So I think that’s well understood at this point. As a result, we are not consolidating these customer assets on our balance sheet.

It must have been a pretty big scramble to do that by this summer’s deadline.

Well, it’s sort of a matter of course around here; when things change, you get out in front of them and address them.

Presumably, your cost of lending could have gone up, or the cost of borrowing could have gone up for your customers. Do you think that when FASB put FIN 46 together it gave adequate consideration to the potential economic impact?

I can’t speculate on what FASB thought when it was issuing Fin 46. I would say that the commercial-paper market works very well. The commercial-paper conduits that we and other banks offer are a valuable service to customers.

Our fees are very small for the service we provide. You can’t be in the business with that level of fees and justify having $55 billion of assets on the balance sheet as long as they are risk-weighted by the Fed. So either the fees would change dramatically, or we and others, I believe, would have gotten out of the business. That would have been a real shame, because this is an important funding mechanism for a number of our customers.

You mentioned that you spoke with FASB about your restructuring effort. But when this was all being hashed out, FASB chairman Bob Herz spoke at a Bond Market Association meeting and gave the impression that the economic impact on the banks was not FASB’s concern; that the concern was “getting the accounting right.” By continuing to keep the conduits off your balance sheet, do you feel nonetheless that you’re operating within the spirit of FIN 46?

Yes. I think everything we’ve done fits within how FIN 46 was written. It addresses the structural requirements to have things off the balance sheet. We’ve reviewed those with everybody, so I believe it does.

And the ultimate cost impact of FIN 46?

It did increase the cost for us in the sense that we needed to restructure these things, which cost us some money. Essentially, we end up sharing our fees with outside investors, so our revenue will be lower than before. But the amount of revenue we get from commercial-paper conduits is—in the context of corporate investment-banking revenues—very small.

FIN 46 may also affect trust-preferred securities [TRUPS]—in this case by requiring that they be taken off your balance sheet. What impact would that have on Citigroup?

Trust-preferreds have been designated by the Federal Reserve as Tier 1 capital up to a certain amount [25 percent] of a bank’s total Tier 1 capital. So it’s an important way to get equity in Tier 1 capital as a bank holding company. The accounting—it’s interesting, and I believe this was an unintended consequence of FIN 46—raises the question of whether you would have to deconsolidate TRUPS. We’ve written a letter to the SEC and we, as well as a number of accounting firms, believe FIN 46 will not cause a change in consolidation for the purpose of TRUPS. But it’s an ongoing debate.

Bottom line, is there potential for a big financial impact? Your 10Q says you would be well capitalized regardless of the outcome.

It won’t matter to us in terms of capitalization. Some smaller banks could feel some pressure. But the Federal Reserve has said that for the time being, it will grandfather in any existing TRUPS for Tier 1 capital purposes. From the Fed’s perspective, the nature of the instrument hasn’t changed, regardless of how it is accounted for. It has said that those who have issued new TRUPS since FIN 46 came out will also receive Tier 1 capital treatment. We issued $500 million in trust-preferreds a couple of weeks ago. We checked with the Fed in advance and it said yes, they will receive Tier 1 capital treatment.

The conflicts between the Fed and the SEC seem to increase as FASB moves ahead to try to simplify accounting….

[Laughing] Simplify accounting!

Maybe that’s the wrong phrase. As FASB tries to change GAAP to react to some of the excesses of recent years, accounting changes aimed at regular companies often conflict with the complicated financial mechanisms in place at banks. And that increasingly seems to put the Fed and the SEC at odds. As CFO of Citigroup, it sounds as though you often end up in the middle, writing letters and trying to explain the issues to both regulators.

FASB has been writing a number of staff papers on a number of issues, partly in response, as you said, to the excesses and abuses that have occurred. I think fixing abuses is good; no question about that. But as FASB comes up with new interpretations or rules, it is important that there be a very serious dialogue with us and others in the industry to make sure that we end up with only intended consequences. A lot of these things aren’t as simple as they might appear. Some of them have more-complicated application for financial-services firms. We are trying very hard to make sure that we’re involved in that dialogue. Eliminating abuse? Terrific. But we need to be careful of potential unintended consequences.

Are you spending more of your time on that dialogue?

Yes. Four years ago, we might have spent five minutes on accounting-policy issues once a month. Now, in my weekly staff meetings, we typically spend 15 to 20 minutes on such issues, plus special meetings. It’s been very demanding.

In the wake of a lot of negative publicity last year, Citigroup has made it a point to present itself as a leader in business practices and corporate governance. During your second-quarter earnings call, Sanford Weill said, “We got the message on reputational risk.” What exactly was the message you got?

he message is that the world has changed. We’ve changed from a period of excess, from a period of glorifying IPOs without profits and dot-comers who went to work and then six months later became multimillionaires on paper. Complicated off-balance-sheet structures were considered clever, and people were lauded for creating complicated structures and attempting to evade things. [Even] your magazine was part of that.

I think the message we got was that it’s time to get back to integrity and good disclosure and good corporate governance. And frankly, I think everybody feels better about that. At Citigroup, we feel we should help lead that process. We should lead by example, because we have some influence on how the rest of the business community acts.

We’ve tried to work hard regarding instituting a number of reforms in how we operate the business, what we do and don’t do with our customers, and how we handle corporate governance at Citigroup itself. We’ve done everything from eliminating cross-board seats to expensing stock options, establishing business-practices committees within each of our businesses, and putting in the reforms you saw in the corporate investment bank. Everything from separating research from investment banking to establishing the net-effect rule about which structured financings we are willing—or not willing—to do with customers.

Of all the firms involved in the global settlement, it’s safe to say Citigroup made the most public statements of contrition—within the obvious bounds of what could be said given the litigation that is still pending. Yet Citigroup also wound up paying the largest fine. Is it possible that publicizing your internal reform efforts actually cost you more, or made you more of a target for regulators?

In hindsight, some of the industry practices around research, around IPO allocations, around structured products were inappropriate. They seemed appropriate at the time. If I can talk about structured products, bankers viewed their job as structuring things subject to accounting firms and law firms signing off on their accounting and legal appropriateness.

We decided we’d have to take some responsibility for how and why our clients do things, and how they disclose them. I don’t know whether that sets us up to be more of a target or less of a target with the regulators.

On the other hand, in a separate structured-financing settlement, the SEC specifically mentioned Citigroup’s cooperation.

The fact that the SEC noted how cooperative we were in the Enron and Dynegy structured-products settlement is a good thing. I want Citigroup to be viewed by regulators as a company that “gets it.” And I think we do get it. I want regulators to view us as a company that is not dragging its feet on reform, but is leading reform. And if it costs us a little bit more money, I think it’s a good price to pay.

During congressional hearings after the Enron meltdown, one of your officers testified, “We do not dictate our clients’ accounting practices. Once we’re satisfied that our clients’ proposed tax and accounting treatments seem reasonable, the accounting judgments are left to the client and its accounting professionals.” Has that changed?

The standard has changed.

So how do you police that among your customers? For example, under your net-effect rule, how do you police how a customer discloses a structured financing?

I don’t think we can be in the business of policing our customers’ accounting and disclosure. That’s why the SEC exists and why external accountants and law firms exist. That’s their job, not ours. If we believe there’s a structured-finance product that is really financing, we ask the company to commit to us that the product will be disclosed as a financing on its balance sheet. If it’s not going to be disclosed as we think appropriate, then the company will have to go elsewhere because we’re not interested in doing that business.

But again, the environment hasn’t only changed for us, it has changed for our customers. There were a number of them that might have been interested in doing the fancier off-balance-sheet things that were being done in the late 1990s, but they’re not interested anymore. I think our customers are on board with the net-effect rule.

In theory, though, what recourse would you have if they reneged on their commitment to disclose it? Do customers have to sign a document stating how they will disclose it?

They have to commit to us that they’re going to do that. But again, we’re not the SEC, so our job isn’t to enforce accounting rules.

Do they have to make some sort of written commitment to a particular type of disclosure with you?

They just have to commit to us that that’s how they’re going to do it.

Initially, Citigroup’s net-effect rule exceeded GAAP and SEC requirements. Now that off-balance-sheet financing must be disclosed anyway, do any of your requirements exceed what is required by GAAP or regulators?

It’s hard to say. There may be things that, from our perspective, should be disclosed clearly as debt although the accounting rules might permit some flexibility. You’d be fine from a Sarbanes-Oxley [Act] point of view because you’re signing that your statements are based on GAAP, but that might not be consistent with our net-effect rule. In those situations, if a customer is looking for us to do the structuring, it must disclose it appropriately.

All this is important, but the most important thing is the change in tone and business culture since the go-go 1990s. There’s always the potential for fraud. If somebody like WorldCom is going to perpetrate a fraud, no amount of rules is going to keep that from happening.

Have you had to walk away from deals as a result of your net-effect rule?

We initially had a couple of tough conversations with clients on the rule. More recently, our clients, as I said, have been on board with this.

What types of structured-finance deals are no longer done?

There’s very little that’s not done. I think some of the more-structured things that Enron was doing—those became very popular as off-balance-sheet financing instruments for utilities. I think those are a lot less popular today for utilities.

The issue with Enron was how it was disclosed and how they talked about it, and what this really meant for their operating business. There’s nothing evil about structured finance per se. It is just that when it is not disclosed properly, there is the potential for misleading investors.

You’re one man. How do you stay on top of all that’s going on at a company with the size and diversity of Citigroup?

This is a big place. We’re in more than a hundred countries. We’re in every major financial-services product. It’s a fantastic perch from which to see what’s going on almost anywhere in the world. That’s one of the exciting things about the job.

The flip side of that is that anything that happens anywhere has an impact on us. So we have to be on top of the risks that exist in the company. And from my perspective—a control perspective—I’ve got to make sure that the controls are in place to ensure that we’re reporting accurate financials and not having operational breaks.

Most important is maintaining a culture of integrity in the finance organization, because regardless of how many controls you try to put in place, if the culture isn’t right, somebody will take advantage of the situation. We spend a lot of time on internal training. We deliberately transfer finance people across businesses on a regular basis to make sure that nobody goes too native anywhere. That’s very important as a control mechanism.

We also have an accountability approach. This was started years ago, way before Sarbanes-Oxley. At the very lowest level of a P&L of a product and a country, the finance person responsible for those numbers has to sign that those are the right numbers, and then that cascades up to the next level.

So there’s a culture of accountability and integrity. That gives me the ability to sleep well at night. The final part is you have to have really, really talented people working with you. We have one of the finest finance functions of any business in the world.

I suppose the upside to being exposed to risks worldwide is that your diversification also gives you natural hedging capabilities.

The most important risk-management tenet is diversification, because you almost never have perfect foresight into the future. We just don’t allow large concentrations of risk anywhere, in any credit, in any country, or in any market.

Second, there must be independence from the businesses. A risk manager who signs off on a loan can’t be the loan officer who is paid for making loans. We’ve structured an independent risk-management organization to provide the right kind of checks and balances as we continue to push business managers to drive revenue growth.

Third, you have to pay attention to risk daily; it’s got to get senior management’s attention. The people in the risk-management function have to feel that they’re doing really important work; they have to have good career paths.

We hate losing money. We just hate it. When you’re in the business of taking risk, every once in a while you’re going to lose money, and we do. In our business plan every year, we have expectations of billions of dollars of credit losses, but we hate it. So we spend a lot of time and energy trying to minimize the losses that we take.

That’s the legacy of Sandy Weill, I assume.

Sandy wants all the return and none of the risk. [Laughs] And he considers that a reasonable request.

One way that banks have minimized risk in recent years is to spread it out into the marketplace. Isn’t there also a danger of spreading credit risk out to market participants that are less able to handle it, are less regulated, or are simply less aware of what types of risk they’re assuming?

I think there may be some players out there that end up taking on credit risk—because they’re buying bonds or credit derivatives or whatever—that are less sophisticated than others. But the reason Moody’s has been so pleased with the performance of the financial-services industry through this downturn is that banks and financial-services firms can take losses that might otherwise be concentrated in a fairly small number of players and spread them out to a large number of players in the marketplace. The result is a stronger banking system. And I think the market has plenty of ability to absorb those.

New Leaf or Fig Leaf?

Citgroup’s list of internal reforms was derided by one analyst as “just-in-time corporate governance,” but CFO Todd Thomson says he wants Citigroup to be a leader, not a laggard. A partial list of Citigroup’s “business-practices initiatives” includes the following:

All research is housed in a new retail brokerage unit, Smith Barney.

Research analysts may not attend pitches, roadshows, or other efforts to solicit investment-banking business.

Investment banking is banned from any involvement in setting analyst compensation.

Analysts must certify to the accuracy and impartiality of their views.

Analysts may not own any securities they cover.

Customers are required to publicly disclose the net effect of structured finance transactions on their financial condition.

Citigroup’s tax department must review and approve all tax-sensitive financial products or strategies.

Stock options are expensed as of January 2003.

Stock-option repricing is prohibited.

Pension-return assumption has been lowered to 8 percent from 9.5 percent.

Interlocking directorships between Citigroup executives and companies affiliated with Citigroup directors have been eliminated.

Directors and their families are forbidden from receiving IPO allocations.